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Catching a bid

Quietly, and without much fanfare, Brent is back at $55/barrel (shhhh…don’t Jinx it). The aftermath of Hurricane Harvey has been chaotic, and with a market that likes to shoot first and ask questions later, it’s led to a lot of (not unwelcome) volatility in oil. There are several more hurricanes steaming westward across the ocean, although it does look like Irma is taking more of an Atlantic track rather than again threatening the USGC (as of the time of writing). But it would appear that the flat price is finally starting to respond to the very strong signals emanating from the physical markets, though we still think it has yet to catch up to the strength being seen in physical crude diffs and spreads.

In fact, the post-Harvey story remains one of complacency. Because of the intense focus on the immediate impacts of the hurricane(s) and little contemplation as to what happens down the road, we think that cracks and product spreads out along the curve remain underpriced. Cracks in particular have gotten hammered this week, but we think this is a misreading of how fundamentals are going to evolve going forward.

We expect product draws to continue over the coming weeks. Product spreads have thus far been mirroring 2005, when Katrina struck the Gulf Coast, with the gasoline market in particular looking like a carbon copy. Gasoline spreads rallied into the storm and have capitulated since it passed, though a lot of refining remains offline. Gasoline cracks also look nearly identical to their 2005 counterparts. Distillates have shown a bit more resilience, and we would reiterate that we still think that as time passes, distillates are likely to be the most bullish of the main contracts. But, as we have said before—2005 is not a good parallel to what is happening today given the vastly changed nature of the US crude and product flows.

Fig 1: RBOB Oct/Nov spread, cents per gallon

Fig 2: October gasoline crack, $ per barrel

Source: Bloomberg, Energy Aspects

Source: Bloomberg Energy Aspects

Meanwhile, as Congress returns from recess, the broader market remains sceptical that the legislative body can actually legislate. On Tuesday, there was a mini risk-off episode in broader risk markets. This is not so unusual in and of itself, given all the things that markets will need to consider this autumn, but what was unusual is that most of the risk assets behaved as expected, with the exception of crude. As equities and treasury yields sold off and gold rallied, Brent actually caught a bid. This has happened a couple of times in the past few weeks. One reason is because many have been short oil while they have been long other assets (in the equity space, shorting oil has been a very strong theme). With the dollar under renewed pressure and the market perhaps questioning the ability of Congress to juggle all these balls at once, it’s worth noting that oil fundamentals are firming just as there appears to be scope for continued dollar correction lower.

The current weakness in treasury yields appears to be the big factor dragging down the dollar, driven in part by the failure of Team Trump to deliver on campaign promises, especially those related to tax reform. As the legislative agenda keeps getting pushed back, prospects for both growth and inflation have diminished. The concern now is that yields will fall to where they were before the election. This is why the congressional agenda is so important and the list of important issues which need to be resolved keeps growing. In addition to tackling tax reform and the debt ceiling, Congress needs to pass Harvey relief legislation. As if that wasn’t enough, it appears that Donald Trump may be adding Iran to Congress’ “to do list”. UN ambassador Nikki Haley gave a speech to the American Enterprise Institute this week essentially arguing why the president just might refuse to certify Iran’s compliance with the JCPOA. If the president chooses not to certify Iranian compliance in October, that does not mean the US is withdrawing from the JCPOA, but it would trigger a 60-day clock for Congress to decide whether or not to re-impose sanctions on Iran. Trump has made no secret of his dislike of the JCPOA, but he appears to be punting the issue to Congress. For now, this is more headline risk than actual risk, but it’s worth watching if a) Trump chooses not to certify Iran as in compliance, and b) if that then leads to a more activist Congress that tries to undermine the JCPOA.

The outlookWTI: Harvey dislocations continue to drive sentiment, and the September fundamentals remain on balance bearish given that most crude production appears, at least on the surface to be returning faster than refineries. Any lasting impact to onshore production is still unknown, and this week EOG Resources lowered its Q3 17 US oil output guidance after it suspended drilling and completion operations and shut in production in preparation for Hurricane Harvey. We would expect to see more of that in the coming days. Ultimately, US domestic production is not going to grow as much as consensus forecasts suggest, so we remain constructive on margin strength and export strength (for more details, see our E-mail alert: Gulf Coast refineries begin ramping-up as crude supply issues are alleviated post-Harvey, but status of Port Arthur remains a concern, 5 September 2017). WTI timespreads sold off aggressively as Harvey hurtled toward the US Gulf Coast, but they have since recouped some of those losses. As refiners continue to return from their storm-related shutdowns, demand for crude will also pick up, as will demand for exports. Given where they have been trading, we remain generally constructive on WTI timespreads.

Brent: With a big chunk of US refining still offline and margins through the roof, there is every incentive for European refiners to run post maintenance. Moreover, exports from the Middle East to Europe were down in August and appear to be on track to fall again in September, though it is still early days. US exports are likely to spike in the coming month, but we think Europe will be well placed to absorb those volumes. With the front part of the Brent curve flirting with backwardation, the incentive to store is gone. Dubai is also now catching a bid, reinforcing the strength in the physical crude markets that has been a theme this summer. Given the strength in margins, we think crude will be bid, and Brent in particular will benefit (see Perspectives: Spare me, 4 September 2017). Currently, Brent prompt spreads are implying a much higher flat price. The last time that spreads in the front of the curve averaged these levels was back in 2014 when the flat price was closer to $70 per barrel. Flat price has completely lagged the fundamental strength in the physical market.

Fig 3: WTI prompt crude spread, $ per barrel

Fig 4: Brent vs 30 day moving avg, $ per barrel

Source: Bloomberg, Energy Aspects

Source: Bloomberg, Energy Aspects

RBOB: Gasoline at the moment appears to be following the 2005 playbook as a huge spike in the prompt has been quickly followed by a near total retracement to pre-Harvey levels. But US government waivers and the resumption of some refining activity with seemingly limited damage is only providing a false sense of security. Much of the refining capacity that is coming back is geared primarily for the export market, while most of the plants still offline mostly supply the domestic market. Any lengthy downtime in Port Arthur will either force up US Gulf Coast gasoline prices to ensure plants that habitually export their output instead sell into the domestic market (including covering the cost of RINs) or draw down US inland gasoline inventories. With importers in Latin America unlikely to release barrels they have contracted due to limited inventory in those countries, in all likelihood US consumers will not bid barrels away from importers because they hold inventory so US stocks will fall to make up the gap in Atlantic basin gasoline supplies. Inventories are likely to continue falling despite refiners coming back (see E-mail alert: US refinery outages biased towards plants that supply domestic market as Irma threatens Caribbean terminals, 5 September 2017)

Distillate: After propane, distillate is probably the most constructive of all the products, more so because of the time of the year and the already constructive trajectory inventories were taking. Moreover, US government forecasts are now projecting a greater likelihood for a La Nina this winter and the cooler temperatures that come with it. Inventories across the US had been falling impressively all year, even with run rates so high for much of the year, and stocks were supposed to build in the fall. However, we now do not expect stocks to rebuild ahead of winter. Normally, about half of the PADD 3 distillate surplus is exported (mostly to Latin America), while the other half goes to PADDs 1 and 2. Between the onset of the agricultural season and the loss of US diesel exports, there will be some real competition between PADD 1, PADD 2 and Latin America for PADD 3 diesel output. At the same time, as refinery runs ramp into November, there will be a lot of resupply available for gasoline markets. But, we still expect to see a lot of inventory loss on the diesel side due to seasonal demand needs. Currently, RBOB vs HO spreads have been coming off in the prompt. But December and most Q1 18 spreads are still flirting with multi year highs. We think that heat should outperform RBOB especially for December and into Q1 18.